Revenue Code 651: Tax Deductions for Simple Trusts
Learn how IRC § 651 provides a tax deduction for simple trusts, preventing double taxation on income required to be distributed to its beneficiaries.
Internal Revenue Code Section 651 provides the framework for tax deductions available to “simple trusts.” This rule prevents the double taxation of trust income by allowing a trust to deduct income it is required to pass on to its beneficiaries. The trust itself does not pay tax on this distributed income; instead, the tax liability shifts to the beneficiaries who receive it.
Requirements for a Simple Trust
A trust must satisfy specific criteria to qualify as a simple trust for a given tax year. The primary requirement is that the trust’s governing document must mandate the distribution of all its income on an annual basis. This means the trustee has no discretion in whether to distribute the income; it must be paid out to the beneficiaries each year. The term “income” in this context refers to fiduciary accounting income, determined by the trust document and local law, not taxable income.
Two other conditions are required for maintaining simple trust status. The trust is prohibited from making any distributions from its principal, or corpus, during the tax year. The trust is also forbidden from making payments or permanently setting aside funds for charitable purposes. A trust that meets these three conditions is considered a simple trust for that year, but its status can change to a “complex trust” in any year these requirements are not met.
Calculating the Trust’s Income Deduction
A simple trust claims its income distribution deduction on Form 1041, the U.S. Income Tax Return for Estates and Trusts. The calculation is linked to Distributable Net Income (DNI), which serves as a limit on the amount the trust can deduct. DNI is a calculated amount that begins with the trust’s total income and is adjusted for items like capital gains that are allocated to the principal.
The deduction a simple trust can take is the lesser of two amounts: the fiduciary accounting income required to be distributed or the trust’s DNI. For instance, if a trust is required to distribute $50,000 of income, but its DNI is calculated to be only $45,000, the trust’s deduction is limited to $45,000. DNI, for the purpose of the deduction, does not include non-taxable income. If the trust’s DNI of $45,000 included $5,000 of tax-exempt interest, the income distribution deduction would be reduced to $40,000. The trust is also entitled to a $300 personal exemption.
Taxation of Beneficiaries
The income that a simple trust deducts is taxed to the beneficiaries who are required to receive it. This occurs whether or not the income was actually paid out during the year. The trust reports this income on a Schedule K-1 (Form 1041) for each beneficiary, detailing their specific share of income, credits, and deductions.
The character of the income earned by the trust flows through to the beneficiaries and is reported on their personal tax returns. For example, if the trust receives qualified dividend income and tax-exempt interest, the beneficiary is treated as having received a proportionate share of each. This character retention is outlined on the Schedule K-1, allowing beneficiaries to apply the appropriate tax rules to each type of income.